Opportunities and Challenges

1. As can be seen from the graph, there is an absence of volatility prior to 1971 under the gold standard. However, once major world economies abandoned gold standard and the fixed exchange rate associated with that, exchange rate volatility increased under floating exchange rate mechanism. Foreign exchange rate risk to be managed by counterparties exposed to foreign exchange rate risk.

2. Opportunities and Challenges • Increased Volatilities • Exposure has increased for the major players in the market as the world economy have seen a major restructuring of financing transactions since march of 1973 (the beginning of floating rate arrangement). • The increased volatility of exchange rates and innovations in derivative products have created opportunities and challenges to corporations. • Friendly regulatory changes in 1980s that increased competition in the financial service industry. • Most firms have been able to rise up to the occasion and adapted to new challenges and prospered. Some have not fare so well and in extreme cases have become dinosaurs unable to adapt to environmental changes and faced extinction. • The Savings and Loans (S&L) and Lehman Brotheres are the classic examples of the dinosaurs unable to manage their exposure.

3. Exhibit 1.2: First difference in 3 Months Treasury bills 1934-2009

4. Laker’sAirline • The mismatch of revenue and cost, • Where the revenue is denominated in one currency and cost is incurred in another currency also create exposure for a firm. • A weak dollar in the early1970s made travel to United States a bargain for British travelers, raising revenue of Laker’s Airline. • The Laker’s Airline borrowed the U.S. dollar to purchase new aircrafts. • The Dollar strengthened against the British pound by the early 1980, thereby making travel to United States very expensive and increasing the pound cost of the dollar to service the dollar denominated debt. The Laker’s Airline was hit by a double whammy and forced the company into bankruptcy.

5. Types of Market Spot Swap Futures Forward This graph shows interrelationship among various markets. For example, the over the counter forward market is fairly connected to its close cousin, the futures market that is operated in an organized exchange, where the contracts are marked to market at the end of each business day by a clearing corporation unlike forward market where the contracts are marked to market at the settlement date. The forward and swap markets connection is derived from the underlying forward contracts, as swap is considered as a portfolio of forward contracts simultaneously taken in a long and a short positions.

6. As can be seen volatility increased after 1997 as Hedge funds became a major deriving force in the Wall Street.

7. Counterparty Credit Risk Management CCRM • CCRM system is composed of: • Limits on the size of the exposure • Haircut • Setting margin; initial and variation margin • Collateral • Establishing risk identification, measurement, and mitigation techniques In order to assess credit risk and limit counterparty exposure

8. Hedge Fund & Intermediaries • Banks are exposed to counterparty credit risk due to their extension of credit to hedge fund, as well as having prime brokerage relationships. • Hedge funds are largely, unregulated private pool of capital provided by accredited investors, (wealthy individuals or institutional investors)

9. Characteristics of hedge funds • Four broadly defined attributes distinguishes hedge funds from other money management funds: • Trading strategies; short selling , derivatives, options, and other HLTS. • Liberal use of leverage, directly through the use of debt, or indirectly through leverage embedded with derivatives. • Opacity to outsider, absence of transparency. • Highly convex compensation, i.e., (2-and-20) set up, dual fee structure. Very high with good performance, but falls very little with poor performance.

10. Assets Under Management

11. Hedge Funds Facts • Hedge funds as of 2005 accounts: • 89% of the trade in convertible debts • 66% of distressed debts • 33% of emerging markets debts • 20% of speculative debts • 58% of credit derivatives in 2006. • Hedge funds survival rate 85-95 percent • 30 percent do not make it after 3-years

12. Systematic risk • Definition has been quite vague in the literature. • A systematic crisis occurring, when a shock affect considerable number of financial institutions, thereby impairing their ability to channel savings into promising investments. • Shocks in one part of the financial system leads to shock elsewhere, threatening the stability of the real economy. • Major damage to the financial system and the economy. • Collapse of LTCM • Financial markets linkage to the real economy, create systematic risk through players such as hedge funds and trading banks. • Optimal level of systematic risk is not zero.

13. Functions of Hedge funds • Liquidity providers, • Risk arbitrage • Price discovery • Efficiency of intermediations

14. Markets for Real AssetsMarkets for Financial Assets Examples of these markets are stock markets, bond markets and foreign exchange spot market, where the underlying asset is the spot exchange rates representing claim on the purchasing power of one currency relative to another currency.Markets for Derivatives This market also is known as the sum zero game market, where the gain of one party is exactly equal to loss of another party. Derivatives derive their value from the underlying assets such as stocks, bonds, commodities or foreign currency spot exchange rates. The derivative markets perform two valuable functions: transferring risk and price discovery. TYPES OF MARKETS

15. Yield Curve for US Treasuries

16. Interest Rate Futures The price column shows the IMM index for eurodollar futures an index of forward (future) interest rate for corporate funding. For example, the IMM index of 95.32 for 90 day Euro-dollar futures imply forward interest rate of 100-95.32, that is equal to 4.68 percent. The rate for 91 day (13 week) Treasury bill futures on 2006-02 as an index of government forward or futures funding is equal to 100-95.73, that is 4.27 percent.

18. TYPES OF RISKS • Macro Risk • Macro risk is the risk of being in the market, which cannot be avoided but can be managed. • Every firm domestic or multinational corporations MNCs face macro economic induced risk such as: • General turn down in economic activity, • Changing political landscape, • War and peace, • Natural disaster or international terrorism that affect individual attitude and expectations which in turn causes change in consumption, investment and financing decisions. • As the individual or firms attitude toward risk and uncertainty changes so is their attitude about how much save or consume and invest/or finance changes over time.

19. Foreign Exchange Risk • Foreign exchange risk is unique to MNCs as the foreign denominated cash inflows or outflows must at some times in future converted to domestic currency of the operating unit creating a windfall gains or losses. • Direct foreign investment (DFI) • Portfolio investment in the form of stocks, bonds and bills and other short term assets entail opportunities for greater return (exchange gains) and higher risk due to foreign exchange losses. • Currency exchange risk, the economic, transaction and accounting consequences of the fluctuation of exchange rates, strongly impacts many businesses in a variety of different ways. • In the early 1980's the tight monetary policy of Paul Volker, the chairman of the Federal Reserve resulted in high real interest rates in the U.S. compared to other countries. • This in turn resulted in a high value of the dollar compared to other currencies, making the U.S exports very expensive and unattractive for foreigners. • Caterpillar, found itself at a disadvantage compared to its main competition Komatsu, a Japanese manufacturer of hydraulic excavators. • Later in the 1980's the strong dollar eased inflationary pressure in the U.S. economy leading to lower inflationary expectations and a decline in the long-term U.S. interest rates.

20. Case History of Losses due to market risk, operational risk and Foreign exchange risk Exhibit 1.11: Case History of Losses of foreign exchange ---------------------------------------------------------------------------------------------------------------------------------------------------- Company Transaction Date Approximate Loss Description Home (country) inducing Loss ---------------------------------------------------------------------------------------------------------------------------------------------------- SocGen Futures 2007 $7 billion Speculative losses stemming from loss (France) of internal control Allied Irish Bank Foreign Exchange Feb 2002 $691 M Rogue trader hides loss over 3 years NatWest Swaption March 1997 $127 M Trader misprice options. reputation damaged Morgan Grenfel Stock Sep 1996 $720 M Speculative loss as trader exceeds his limit Sumitomo Futures June 1996 2.6 Billion Unauthorized (Japan) copper trader over three years Daiwa futures Sept 1995 $1.1 billion Unreported loss over 11 years Bankers Trust swaps Oct 1994 $150 M Legal risk and reputational damage -------------------------------------------------------------------------------------------------------------------------------------------------------

21. Political risk • refers to changing political landscape and its effects on the way individuals or firms conduct business in the world market. • New political arrangements may impose various restrictions on the flow of goods and services. • The risk of takeover or expropriation of foreign owned assets or nationalization of foreign assets as proxy for political risk has been mitigated by a disciplining mechanism of the international capital market. • This risk was significant in the past and firms mostly multinationals used to spend precious resources for identifying, quantifying and micro managing it in cases involving acquisitions, foreign direct investment and portfolio investment.

22. RolloverRisk: the risk of being forced to close out the position without being able to renew the contract at the market prevailing price or rate. • This risk is also synonymous with the availability of the fund. • For example a financial institution may extend a 6-months fixed rate loan to a party and be able to fund the loan for 3-months, therefore the institution is exposed with the risk of availability (rollover) for the funding of the loan for the remainder of the next three months for which some type of hedging in the forward or futures market is necessitated to mitigate the risk of higher interest rate in the next 3-months. • Risk Risk: the risk of not knowing and understanding the ramification of the type of the agency relation one has entered and the risks entailed in such relationship. The risk of not understanding the risk of security the (long or short) position one has taken

23. Risk Management Process • Identification • Measurement/Assessment • Monitoring • Control/ Mitigation

24. Break down of Financial risks Commercial Investment Treasury Retail Asset Banking Banking Management Management Management operational Credit Market Commercial banks are exposed to great deal of credit risk as they make loans to individuals and corporations. They are exposed to market and operational risk. Bank regulators require that banks to hold capital reserve for absorbing losses due to credit, Market, and operational risk.

25. Credit Risk • The counterparty credit risk is a high frequency and low severity risk that is mitigated by banks through bad loan loss reserves. • Credit risk originates as the counterparties are unwilling or unable to fulfill their contractual obligations.

26. Operational Risk • The Basle Committee on Banking Supervision BCBS reported recently that, “An informal survey …highlights the growing significance of risks other than credit and market risks, such as operational risk, which have been at the heart of some important banking problems in recent years.” • Few definitions: • Any financial risk other than credit and market risk. • Risk arising from operation, such as back office problems, failure in processing transactions and in systems, and technology breakdown, • The risk of loss from failed internal processes, people, and systems, or from external events

27. Market Risk • Risk of sudden shock, which could damage the financial system that the wider economy would suffer is an example of systematic or market risk. • Contagious transmission of the shock due to actual or suspected exposure to a failing bank or banks. Followed by flight to quality. • Panicky behavior of depositors or investors or • Interruption in the payment system

28. Liquidity Risk • Liquidity risk arises from asset liquidity and funding liquidity: • Asset liquidity risk. Associated with the absence of an efficient secondary market in which a long or short position can not be liquidated at the prevailing market price. • Funding liquidity risk. Arises when a firm is unable to rollover its maturing loan, unless substantial collateral is posted or rate increased.

29. Risk Interactions • Assume that on December 31, XYZ has a spot contract to buy £10 million in exchange for delivering $16.5 million in two business days from bank 1. This simple transaction has the following risks. • Market risk • Credit risk • Settlement risk • Operational risk $16.5 M XYZ Bank 1 £10 M

30. Market risk: Suppose after few hours exchange rate changes to $1.50/£. The trader cuts the position and enters a spot sale with Bank 2. The loss of $1,500,000 to be realized in two B/days. • Credit risk: The following day, Bank 2 goes bankrupt. XYZ enters a new trade with bank 3, and spot rate has fallen to $1.45/£, the gain of $500,000 with bank 2 is now at risk.

31. Herestat Risk • Settlement risk: Suppose XYZ bank wires $16.5 million in the morning to bank 1, who defaults at noon and does not deliver £10 million. This is known as Herestatt risk. • Operational risk: Suppose the XYZ bank wired the $16.5 million to a wrong bank. The back office gets the money back after 2 days. The loss of interest on the amount due is attributed to operational risk